Arnold Kling  

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EconLog Book Club: For a Ne... Summers' Warning?...

Bill Gross writes,

The U.S. and global financial systems require credit creation and foreclosure prevention, not bank nationalization as currently contemplated by some.

As you know, I differ. I want foreclosures and bank shutdowns.

Nick Schulz points me to Chistopher Whalen.

In my view, CDS and the entire OTC derivatives market represents a form of regulatory arbitrage - a retrograde and deliberate evasion of established prudential norms masquerading under the innocent guise of innovation.

As you know, I agree. I want the CDS market to die a natural death. I think that without government support, neither mortgage-backed securities nor credit default swaps would survive. I could be wrong about CDS. But I'd like to see what happens in a world where the buyer of a CDS has no assurance that the government is going to bail out his counterparty, so he has to find some other way of guaranteeing that the counterparty will fulfill the contract.

Finally, Daron Acemoglu on the importance of long-term growth relative to cyclical output gaps.

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COMMENTS (9 to date)
dWj writes:

I disagree with you about the CDS market, but I'd also like to see what happens in a world where the buyer of a CDS has no assurance that the government is going to bail out his counterparty. (I don't think most default swaps were purchased with the expectation of a government backstop, at least not by big financial firms. They've been looking at credit risk on credit derivatives for several years at least. AIG obviously proved (unnaturally) not to have much counterparty risk, but anyone who was owed money on a CDS by Lehman took the appropriate hit. It's hard to tell with some current counterparties how many of them would still be around without government intervention and how many wouldn't.)

Greg Ransom writes:

Bill Gross wants all your money.

His last proposal was to "nationalize" a significant proportion of the housing stock -- and DESTROY IT.

When Bill Gross writes something, tt's all about Bill, and how he can persuade the government to do stupid things that will move money out of your bank account and in to his own.

Methinks writes:

Here's why I don't like the Pimp of Pimco (Bill Gross - like Madoff and Cox, an unfortunate but appropriate name). Recently, he filled his portfolio with MBS tranches and the preferred stock of banks. Then, he found every camera he could stick his mug in front of and started an all out campaign for government programs that would essentially bailout his funds. And Bill Gross wants to talk about regulatory arbitrage? I'm laughing so hard I'm choking.

Arnold, I listened to your interview about CDS on Econtalk and I don't think you understand some key things about CDS. In fact, myself and a fixed income derivatives trader took notes from the econtalk so that we could privately email you but got too busy. At least two of your assumptions about CDS are simply wrong. For one thing, not everyone who wants to purchase a CDS can. For another, there are actually natural sellers and natural buyers of CDS. There's more, but I would have to consult my notes to jog my memory. If you are interested in our feedback via an email, please let me know. Maybe I would benefit from reading more on your MBS theory, but I don't see why MBS should be that different from the ABS backed by assets like credit card receipts. Perhaps the problem is not the assets backing the MBS but the government distortion to mortgages that is then passed on to MBS buyers.

dWj writes:

Incidentally, one of the important ways in which banks deal with the counterparty risk on their derivatives is by making margin calls when the market values of those derivatives and their underliers expose them to too much risk from the counterparty failing. Another is by buying credit default swaps on those counterparties. You have been on record opposing both of the major technologies that actually allow banks to protect themselves from counterparty risk.

Methinks writes:

dwj is absolutely correct regarding CDS. In addition, banks will only deal with institutions of a certain size and credit rating. If you're a a relatively small hedge fund or trading firm firm (relative to, say, Lehman), good luck getting anyone to sell you a CDS. Arnold assumes that if the market declines, everyone will rush out to hedge with CDS. The problem with that is that the seller of the CDS has the same information the buyer does and will price in the change in the environment (this is why "dynamic hedging" doesn't work) and if you're not a counterparty the institution has pre-approved based on size and credit rating, you will be getting nothing at all. So, there's very little chance that, as Arnold claims, the risk from CDS grows exponentially during a crises (if I remember correctly, that was one of his anti-CDS arguments).

Of course, that leads us right back to the credit rating agencies. If the credit rating agencies assign an undeserved high credit rating, then the counterparty to the CDS transaction is taking on more risk than it thinks.

Kevin writes:

I agree with dwj and Methinks. I would suggest in addition that losses that accrue to option writers who rely on ratings agencies are a form of creative destruction.

Methinks writes:


The only problem with that logic is that there's no competition among credit ratings agencies. There are credit ratings agencies which are certified by the SEC as NRSROs (Nationally Recognized Statistical Rating Organizations) whose rating must be followed by regulated institutions. Those CDS writers (and buyers) who relied on the credit agencies pretty much didn't have a choice because doing your own credit analysis on every counterparty is prohibitively expensive and market participants were lured into a false sense of security that the ratings agencies had to meet some high standards to qualify as a NRSRO. Once the oligopolies were created, there was no competition to ensure performance by these credit ratings agencies (as should be expected). That's another example of how government and regulation distorts the market and then scream "market failure".

Mike Rulle writes:

Re: CDS or any OTC Derivative

The OTC derivative market has achieved regulatory "disparity" It is unclear "arbitrage" is the right term. I think of arbitrage as a riskless or quasi-riskless profit transaction. In this issue, we really mean "capital requirement" inconsistencies or disparities.

There are 2 forms of disparity as far as I can tell. One is "cash disparity", the other "capital disparity". The OTC market permits less cash collateral than futures exchanges for comparable risks (discussions of OTC structure flexibility not discussed here). Counterparties can choose who to require upfront cash from and daily maintenance from.

This led to the AIG fiasco. It did so because AIG's own risk "framework" permitted excessive risk, in retrospect of course. Excessive risk means excessive leverage in this instance. The "Street" was willing to lend immense "tail risk" which rebounded back onto them. This disparity can be corrected by requiring exchange like (or lite) collateral requirements. This way, AIG (like Ameranth the hedge fund versus LTCM the hedge fund) can choose to blow themselves up while not blowing others up.

The other disparity is relative to real loans and real underlying securities (speaking of CDS only). The regulators somehow believe that by putting an instrument in a trading account makes its capital needs lower. CDS are in trading accounts (as are some loans and bonds--I am unclear as to capital disparities here--maybe someone can help me out.). But, for certain, there is capital disparity when securities/loans are held outside trading accounts. There is a capital advantage to holding all credit in trading accounts.

There should be changes here. But having said this, it is unclear to me that these issues were anything but tangential to causing or furthering the current crisis---with the exception of AIG which should have been containable and probably was contained, however irritating the Government's choice was.

Mark T writes:

I think you are totally wrong about CDS's. A CDS requires a counterparty who is out of the money to post collateral for its contingent debt if its credit rating falls to certain levels. This is why AIG had such a sudden cash need in September when it was to be downgraded. CDS relies on private credit regulation not the prospect of a government bailout. (it's true that AIG was bailed out but that was after all those CDS's were created). CDS issuers are not regulated banks and rarely are they regulated broker dealers. They are usually offshore affiliates of the bank and broker-dealer.

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